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Accounts Receivable Factoring: Everything You Need To Know (2024 Guide)

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What is accounts receivable factoring?

Accounts receivable factoring or invoice factoring is a financial practice whereby a company sells unpaid invoices (or receivables) to a third-party company (known as a factoring company) at a discount to get immediate cash in advance.

The factoring company pays the business a major percentage of the invoice amount in advance. They remain in contact with the customers for the payments after that. Once they receive the total amount from the customers, they pay the business the remaining amount minus the fees (known as the factoring rate).

AR factoring is particularly helpful for small businesses that want to maintain cash flow while staying away from bank loans. This practice, however, is only applicable for companies that sell on credit terms, meaning that the vendor (the company) sells a good or service and generates an invoice to its purchaser with a due date (30 – 90 days).

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How does Accounts Receivable factoring work?

It’s simple to understand accounts receivable factoring if split into steps.

Step 1: You submit your invoices to the factoring company that verifies them against their predefined eligibility criteria. You can either submit the invoices manually or with an invoicing software if the factoring company supports that option.

Generally, a factoring company gives 70% to 90% of the invoice amount in advance. For example, if the invoice amount is £10,000 and the advance rate is 80%, you will receive £8,000 in advance. You can use this cash as a working capital for payroll, operational expenditures and taking on new client projects.

Step 2: The factoring company assumes the responsibility of gathering the payments from your customers based on the agreed payment terms (such as the due date). It’s generally between 30 to 90 days.

Step 3: Once the overall payment has been collected by the factoring company from the customers, they deduct their fees (which are generally 1% – 4% of the total invoice amount or a percentage of the advanced amount) and pay you the remaining amount.

Types of accounts receivable factoring

Generally, there are 6 types of factoring accounts receivable.

1. Recourse factoring

Factoring of receivables with recourse involves selling accounts receivable to a factoring company, with the business taking on the risk of non-payment. If the customers fail to pay, the business must repurchase the invoices (there are different types of invoices) from the factoring company. This sort of factoring is commonly employed when a business is confident in its client’s creditworthiness.

2. Non-recourse factoring

Non-recourse factoring shifts the risk of nonpayment from the business to the factoring company. If a customer fails to pay, the factoring company bears the loss. This option offers additional safety for business, but it frequently comes with greater fees. It is appropriate for sellers concerned about client credit risk.

3. Spot factoring

Spot factoring allows the business to pick and sell specific invoices to a factoring company without committing to a long-term partnership. It gives them flexibility and fast cash flow while maintaining control over all accounts receivable. Spot factoring is appropriate for businesses with fluctuating cash flow or invoice quantities.

4. Regular factoring

Regular factoring is the continual selling of accounts receivable to a factoring company. The factoring company advances a part of the invoice amount upfront and collects payments directly from customers. This sort of factoring offers continuous cash flow and administrative relief, making it ideal for businesses with predictable invoicing cycles.

5. Notification factoring

Notification factoring, commonly referred to as disclosed factoring, involves notifying customers about third-party involvement in invoice payments. The factoring company receives payments directly from consumers while informing them of the change in payment instructions. This method of factoring ensures openness between the business, factoring company, and customers, resulting in a seamless payment process.

6. Non-notification factoring

Non-notification factoring, also known as undisclosed factoring, gives the business complete control over invoice payment and customer relations. Funding is provided by the factoring company without informing clients of the arrangement. Businesses that would rather maintain control over invoicing procedures and consumer confidentiality may consider this option.

Calculation of Accounts Receivable factoring

The calculation of accounts receivable funding is a simple process. It can be calculated through this simple formula.

Funding amount = Total invoice amount x Advance rate – Factoring fee

Let’s understand it with an example.

Company A invoices customers £15,000 for services rendered, with payment due in 3 months. They decide to factor through Ms. Maria who offers an advance rate of 75% and charges a 3% fee on the total invoice amount. Let’s calculate the funding amount based on the formula above.

Total invoice amount: £15,000
Advance rate: 75% which means £15000 x 75% = £11,250
Factoring fee: 3% which means £15000 x 3% = £450

Funding amount = Total invoice amount x Advance rate – Factoring fee
Funding amount = £15000 x 75% – £450
Funding amount = £11,250 – £450
Funding amount = £10,800

You’ll receive a funding amount of £10, 800 from Ms. Maria.

After 3 months, on the due date, Ms Maria will pay you the remaining amount i.e. 25% of the total invoice amount (£3,750). As a result, you receive a total of £14,550 from receivables instead of £15,000.

Benefits of accounts receivable factoring

1. Better customer service

Since factoring provides businesses with cash flow, they can offer flexible payment terms to their customers. This improves customer service in 2 ways.

  • Customers get the flexibility to pay for invoices 30-90 days after they have bought the product or service.
  • Since it’s the factoring company that is responsible for collecting the customer payments, the business can use this saved effort to improve other parts of the customer service like better chat systems and data insights, etc. A good factoring company has certain systems in place that allow it to collect payments efficiently.

2. More reasonable than loans

Since loans require collateral and impact the credit rating of a business, there’s a risk involved in borrowing money from the banks. But that’s not the case with factoring.

It also enables businesses to be in more control of the loan process in comparison to bank borrowing. In case of the bank loans, you have to pay monthly payments that may strain your cash flow. Also, if you’re unable to submit collaterals, your credit score and future cash flow are negatively affected.

3. Sorts the cash flow problem

Cash flow is integral for the growth of a business. If you have outstanding invoices, it can hamper the cash flow that burdens you while meeting payroll and paying monthly expenses. With accounts receivable factoring, your business gets immediate cash which keeps your operation running efficiently.

4. Frees you from credit management

Since you outsource the responsibility of credit management and collection to the factoring company, it reduces the administrative burden on your business. This allows you to focus on core operations and improvement plans.

Disadvantages of accounts receivable factoring

1. High cost

Accounts receivable factoring can have fees higher than traditional bank loans. Since they charge a percentage of the total invoice amount as a fee, this could diminish the profits of businesses, especially if the sales volume is high.

2. Negative customer perception

The involvement of a third-party factoring company in the payment process may affect customer perception. They may think that the business is unstable and cash flow negative, which can damage their trust and loyalty.

Difference between accounts receivable factoring and financing

“Accounts receivable financing vs factoring” is a common debate among the financial department of a business. But what are the differences?

  1. In factoring, the business sells its invoices to the factoring company but it doesn’t sell them in case of financing. In financing, they receive a long against them.
  2. Factoring completely gives the ownership of the invoices to the factoring company but that’s not the case with accounts receivable financing.
  3. In factoring, it’s the responsibility of the factoring company to receive the payments from the customers. In financing, though, the business continues to manage collections.

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In the process of accounts receivable factoring, the business sells its invoices (or receivables) to a third-party factoring company. The company immediately releases cash (which is a large percentage of the total invoice amount) and then collects payments from the customers in the next 30-90 days.

The factoring company earns money through its factoring fees. It is generally 1% – 4% of the total invoice amount or 5% – 10% of the advanced amount. Notably, the factoring company advances the majority of the invoice value to the business.

To be validated for factoring, your business should have creditworthy clients, a factoring application, a business bank account, a tax ID number, an accounts receivable ageing report (in some cases) and some form of personal identification.

Written by:

Henry Baker
Henry Baker
Henry Baker, an adept financial & business copywriter in England, boasts a decade-long career collaborating with top-tier UK financial institutions. Renowned for his skill in translating intricate finance into captivating content, he's a trusted authority in simplifying complex concepts for diverse audiences.